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Session 7-WACC
Session 7-WACC
Session 7-WACC
WINDHOEK, NAMIBIA
6-10 October, 2014
Harm Aben
ITU Expert
1
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Session 7:
Weighted Average Cost of Capital
(WACC) – theory and practice
2
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Overview
An operator requires capital to finance its investments in the
production of the regulated service(s)
Cost-based price regulation needs to take account of these
investments and allow the regulated firm a reasonable rate of
return on capital employed (ROCE)
Companies raise capital through a mixture of debt and equity
WACC is the average of the cost of each of these sources of
financing, weighted by their respective usage
WACC represents the minimum rate of return the regulated firm
must earn on its invested capital to finance its debts and provide
sufficient returns to investors
WACC is thus the minimum return that a regulator should allow
in setting regulated prices
3
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Introduction to WACC
4
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
What is WACC?
A firm’s assets are financed through a mixture of debt and
equity
The returns required by the providers of these two forms
of capital tend to be different
Debt holders face a different level of risk to equity holders as
they have a prior claim on a firm’s earnings
WACC is the average of the cost of each of these sources
of financing, weighted by their respective usage
It is the minimum expected return investors of all forms of
capital require in order to invest in a business
It is thus the minimum return that a regulator should allow
in setting the price(s) of regulated services
5
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Return of capital
(i.e. depreciation)
Capital expense
(if any)
Operating
costs
7
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
8
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
9
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
1
0
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Calculating WACC
WACC may be measured either in nominal or in real terms
i.e. the real WACC is expressed in constant terms and so
excludes the effects of inflation
The WACC should be consistent with the choice of price base
i.e. if prices are regulated in nominal terms, the cost of capital
should also be expressed in nominal terms
WACC may be measured either pre-tax or post-tax
Post-tax WACC reflects adjustments to allow for corporate tax
payments (in addition to interest payments and returns on equity)
Used for discounting free cash flows (e.g. commercial valuations)
Pre-tax WACC is used for tariff regulation because the revenues
generated need to be sufficient to pay any tax liabilities
1
1
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
EBITDA
Return on capital
EBIT
employed (ROCE)
Return of capital
DA
(i.e. depreciation)
Operating
costs
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2
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
WACC formulae
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3
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Tax considerations
Corporation taxes affect providers of debt and equity differently
Interest payments on debt reduce profits and the tax liability
Equity providers receive dividends from post-tax profits
The cost of equity is naturally expressed on a post-tax basis
i.e. CAPM (discussed shortly) does not incorporate tax
considerations
A pre-tax cost of equity is obtained by “grossing up” post-tax
returns by the applicable tax rate
The cost of debt is naturally expressed on a pre-tax basis
A post-tax cost of debt is obtained by deducting the tax liability
The difference between the pre-tax and post-tax debt yields is
the “tax shield”
1
4
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
1
5
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
1
6
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
17
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
1
8
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
19
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
2
1
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
2
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ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
2
3
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
2
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ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Cost of debt
Cost of debt Tax rate Gearing ratio Cost of equity
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
25
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Cost of debt
The cost of debt reflects the cost the regulated firm has to
sustain to obtain capital from financial institutions or through
loans from other companies.
The cost of debt is the sum of the risk-free rate (Rf) and the
margin (premium) that lenders require above the risk-free
rate
This is the pre-tax cost of debt
May be adjusted by the tax shield to reflect that interest
payments on debt reduce the taxable profit of the investment,
and hence reduce the tax liability and the effective post-tax cost
of serving the debt
This would produce a post-tax estimate of WACC
We are interested in the costs of long-term debt only
2
6
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
2
8
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
2
9
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
0
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Debt premium
Cost of debt Tax rate Gearing ratio Cost of equity
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
3
1
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
2
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
3
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
4
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
5
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
6
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Cost of equity
Cost of debt Tax rate Gearing ratio Cost of equity
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
37
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Cost of equity
The cost of equity is the return required by shareholders on
their investment as a form of compensation for the risk they
bear by making such an investment
The standard framework for calculating the cost of equity is
the Capital Asset Pricing Model (CAPM)
The preferred approach of most regulators
A fundamental concept in investment theory
Other methods for calculating cost of equity are:
Gordon’s Dividend Growth Model (DGM)
Arbitrage Pricing Theory (APT)
Fama – French three factor model
Real Option Theory
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8
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
3
9
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
4
0
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
Use the same risk free rate as was determined for the cost of
debt.
4
1
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
Bottom-up beta
Negatives:
A homogenous sample of companies may turn out to have
heterogeneous un-levered betas
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4
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
4
8
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
The additional return above the risk free rate that is required to
compensate an average investor for investing in equities of
average risk
Represents the investors’ expected returns
A market factor, not company-specific
Calculated as the difference between the return on the equity
market (Rm) and the risk free rate (Rf)
Can be contentious as a wide range of estimates can be
derived from commonly-used estimation techniques
Lower EMRP means lower prices in the short term; a higher
EMRP means increased investment incentives
Derived from either ex post estimations or ex ante estimations
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9
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
5
2
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
5
3
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
54
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
5
5
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Equity
Risk free rate Beta market risk Country risk Small
(Rf) (β) premium premium company
(Rm-Rf) premium
Capital asset pricing model
Equity
Risk free rate Tax rate Gearing ratio Risk free rate Beta market risk
Debt premium (Rf) (β) premium
(Rf) (t) (g)
(Rm-Rf)
Capital asset pricing model
57
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Divisional WACCs
Differentiated WACCs may be set for different units or projects
within the one regulated firm
i.e. a firm’s equity beta is the weighted average of the betas of
the various businesses that the firm is engaged in
Made difficult by lack of capital market data at divisional level
Example: Ofcom in UK re BT (2005)
Copper access network Rest of BT Combined
Asset beta 0.9 1.23 1.1
Pre-tax WACC 10.0% 11.4%
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0
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Group Exercise
61
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Group exercise
Given:
Risk free rate (RF) = 5.0%
Equity Market Risk Premium (EMRP) = 6.0%
Equity Beta (β) = 1.20
Corporate tax rate (t) = 30%
Debt premium (DP) = 1.0%
Gearing: D/(D+E) = 30%
Please calculate:
Post-tax cost of equity
Pre-tax cost of equity
Pre-tax WACC
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2
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Post-tax CE = RF + (β x EMRP)
Post-tax CE = 5% + (1.2 x 6%)
Post-tax CE = 12.2%
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ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice
Pre-tax CE = Post-tax CE / (1 - t)
Pre-tax CE = 12.2% / (1 - 30%)
Pre-tax CE = 17.4%
6
4
ITU training workshop on Strategic Costing and Business Planning for Quadplay
Session 7: Weighted Average Cost of Capital – theory and practice